Management incentives

    Owners pay executives a base salary, but they also tie remuneration to profits by

payment of various forms of profit-related incentives. Examples include profit bonuses, fixed-term contracts which are renewable if a profit target is reached,

and share options. Share options are both a reward for past performance and an

incentive to future effort, since a rising share price will increase the value of the

options. Another possibility is for shareholders to apply the ‘stick’ of critical

review of management performance at annual general meetings.

    Profit-related incentives are only a partial answer to the problem of divergent

objectives._1 First, the link between executive pay and managerial effort is difficult

to quantify. At the time of the takeover of Chrysler in 1998, Daimler executives

were surprised to discover that the compensation package given to one senior

Chrysler executive exceeded the collective remuneration of Daimler’s entire executive .Did the Chrysler executives really work all that much harder

as a result? They certainly worked less effectively, since Daimler was taking them

over . Second, a more difficult problem is that the relationship between a firm’s profitability and managerial effort can be erratic. Profits can rise or fall because of

macroeconomic developments or because of a run of good or bad luck. The 1990s

was a prosperous decade for business: recovery from recession, low inflation and

falling unemployment. Profits boomed as did corporate pay, but it would be hard

to argue that the high remuneration caused the economic boom. Proof of the

pudding in this instance may well be executives’ reluctance to rely too much on

profit or share-price-related remuneration. Even after the share price and profits

collapse of 2001_–_03, remuneration committees awarded hefty pay increases to

senior executives, much to the chagrin of shareholders. Minimum service contracts

and ‘golden parachutes’ also moderate the impact of profit-related incentives. Not surprisingly, empirical studies indicate that the correlation between executive pay and company performance is weak._2

    Despite these qualifications, shareholders continue to pay high levels of remuneration to their executives. Compensation of the highest paid executives has

escalated and the gap between executive and shopfloor pay has widened. In the

1970s, the typical chief executive of a large American company earned about 40

times more than the average factory worker. Nowadays, the same executive earns

over 475 times more. Executive pay was rarely out of the news in the UK, with

attention focusing on the pay of senior executives of several privatised industries.

Executive share option schemes were particularly popular in the US. In 1998

alone, 92 of America’s 200 leading chief executives were given options with an

average minimum value if exercised of $31m._3 Of course, high executive remuneration may prove a good bargain for the owner-shareholders if they achieve even a mild motivation effect. Shareholders may also acquiesce in high pay for

their executives because, being dispersed and numerous, they have little

economic incentive to monitor management directly. An individual shareholder

will bear heavy costs for organising such monitoring, but the benefits will accrue

to all other shareholders. Hence each individual shareholder has an incentive to

sit tight and hope that another shareholder will take the initiative. This is an

instance of a pervasive problem in economic life called the free-rider problem.

    The need to bind executive pay more closely to profit performance has been a

prevailing theme of debate during the past few years. The rash of corporate scandals

in the US, in companies such as Enron, WorldCom, Tyco International,

Global Crossing and Adelphi Communications to name but a few, exposed the

vulnerability of shareholders and employees to malpractice by top executives and

accountants. Misstatements of profits through what were euphemistically called

‘aggressive’ accounting practices and the abuse of executive incentive schemes

were exposed. Share option schemes were often set up with blithe disregard of the

interests of shareholders, and their cost to the firm was not charged in a transparent

way against the profit and loss account. The Sarbanes–Oxley Act of 2002

was enacted in order to redesign the regulation of US publicly listed firms, the

composition of their boards and their reporting practices. A new Accounting

Oversight Board has been set up to review company audits. Europe has to a large

extent avoided American-style excesses. In Britain, the Cadbury Committee

recommended that executive remuneration committees should be composed

primarily of non-executive directors, and the Greenbury Report oncorporate governance made further recommendations, one being full disclosure of directors’ remuneration as a way of enhancing accountability.